Q&A with François Divet
This is the first of two Q&As with François Divet, Head of ILS, where he’ll tell us about the basics of this unique alternative asset class, as well as what investors should keep in mind when selecting an ILS manager.
What are Insurance-Linked Securities, and how do catastrophe bonds generate returns?
Insurance-Linked Securities are floating-rate instruments where the underlying risk is not credit risk, but insurance risk — mainly natural catastrophes. Also known as catastrophe bonds (cat bonds) these instruments effectively provide protection to an insurer or reinsurer against a predefined event, such as a US hurricane or a Californian earthquake.
In return, we receive a coupon composed of two elements. First, there is a fixed spread — the premium paid by the sponsor for transferring that risk. Second, there is a floating-rate component generated by the collateral, which is held in a fully funded special purpose vehicle.
If no qualifying event occurs, we earn that coupon and receive our principal back at maturity. If a major event breaches the agreed thresholds, we may lose part or even all of the principal. So the return is fundamentally driven by insurance premia, not by corporate credit risk.
How do cat bonds differ from traditional fixed income?
Although cat bonds are technically fixed-income instruments, the risk driver is completely different. We are not exposed to economic cycles, corporate earnings or sovereign fiscal dynamics. We are exposed to physical catastrophe risk.
The duration is usually around three years at issuance and shorter at portfolio level. But the real differentiator is correlation. Historically, ILS have exhibited very low correlation to equities and traditional credit markets. That diversification benefit is one of the main reasons investors allocate to the asset class.
What risks are investors actually taking — and what causes permanent loss versus mark-to-market volatility?
The risk we are taking is event risk. If a sufficiently severe insured event occurs, we can suffer a permanent capital loss on that instrument. However, not all drawdowns are permanent. Mark-to-market declines can also result from shifts in supply and demand in the secondary market, or from an increased perceived probability of loss while an event is developing. In those cases, prices may fall temporarily even if the bond ultimately redeems at par.
So there is a clear distinction between realised loss — triggered by an actual event — and temporary volatility driven by market dynamics.
Why do insurers issue cat bonds rather than rely solely on traditional reinsurance?
Insurers use both traditional reinsurance and capital markets solutions. ILS is both a complement and, in some ways, a competitor to the traditional reinsurance market. One key advantage of cat bonds is that there is no counterparty credit risk. The collateral is fully funded and segregated in an SPV. In contrast, with traditional reinsurance you are exposed to the creditworthiness of the reinsurer.
Another important difference is maturity. Cat bonds typically provide three years of protection, whereas traditional contracts are often renewed annually. That allows insurers to lock in pricing for longer. In some cases, using capital markets can also strengthen an insurer’s negotiating position with traditional reinsurers.
How does diversification in ILS work, and why can’t it eliminate tail risk?
If you invest in a single cat bond, you can lose 100% of your investment. So diversification is absolutely essential.
We diversify across perils and regions — for example US hurricane, US earthquake, European windstorm or Japanese earthquake. We diversify geographically at a lower regional level. For example, within the US hurricanes, exposure to Texas is not the same as exposure to Florida. We also diversify structurally, across senior and junior layers and different trigger types.
That said, we cannot eliminate tail risk entirely. Many bonds are exposed to peak perils such as US hurricane and US earthquake. If a truly extreme event occurs in those regions, multiple bonds in a portfolio may be affected simultaneously. Diversification reduces drawdowns, but it does not remove systemic catastrophe risk.
How is ILS different from mortgage-backed securities, and could it trigger a crisis?
I think it is fundamentally different. First, the underlying risk is physical catastrophe risk, not credit and interest-rate risk. Second, cat bonds are fully collateralised — there is no embedded leverage. Third, insurers cannot cherry-pick policies to offload. They transfer defined books of risk on an all-or-nothing basis.
In the mortgage market prior to 2008, counterparty and leverage were key problems. In ILS, those structural weaknesses simply are not present. In addition, the asset class has low correlation with broader financial markets. For those reasons, I do not see the same systemic risk dynamics.
How do you decide which perils and regions to emphasise?
We operate within clear portfolio guidelines. We target a specific expected loss at fund level — typically around 2–2.5% — and we apply hard limits by peril and geography.
US hurricane remains the largest risk in the market, followed by US earthquake. But we manage exposure carefully to control downside risk. We are not trying to trade the market actively; once we are comfortable with a bond, we typically hold it to maturity unless conditions change materially or when the bond is no longer at risk due to the seasonality of the underlying perils covered.
What distinguishes a strong ILS manager over a full cycle?
I think the best way to assess a manager is over multiple cycles — including heavy loss years such as 2017 or 2022, as well as benign years.
A strong manager maintains discipline, limits drawdowns during severe events and avoids reaching for yield late in the cycle. Diversification may reduce returns slightly in quiet years, but it protects capital when large events occur. That consistency is critical.
Blog 2
What attracted you personally to ILS?
ILS sits at the crossroads of (re)insurance and capital markets. With an actuarial background, I find that combination intellectually compelling. It requires both quantitative modelling and financial structuring expertise.
The market continues to innovate, with new perils such as cyber emerging. That evolution keeps the asset class dynamic and stimulating.
How much do you rely on models versus judgement?
We rely heavily on catastrophe models, both third-party and internally developed. They are essential for quantifying expected loss and tail risk.
However, we do not follow models blindly. Where we believe risks are under-modelled — for example US wildfire or other secondary perils such as convective storms — we apply additional loadings to reflect our own view of the risks.
Beyond modelling, structural features such as reset clauses and extension risk matter a great deal, and they require judgement. The quality of the sponsor of the cat bonds on the data provided and their capacity to accurately and in a timely manner report post-event losses are also fundamental for indemnity deals. So I would say it is a combination of quantitative modelling and qualitative assessment.
How do you mitigate downside if the models are wrong?
We mitigate downside risks in several ways. First, we impose hard exposure limits by region and peril, independent of model outputs. Second, we stress-test model assumptions by increasing the frequency and the severity of the events. Third, we may avoid risks that we consider insufficiently well-modelled or increase the required return to a level where it no longer makes sense to invest. We also diversify structurally — across layers, triggers and geographies. Even if two bonds reference the same peril, they may not respond identically to an event.
Finally, we monitor tail metrics such as 99% Value-at-Risk at portfolio level. Risk management is multi-layered; it does not rely on a single model output.
How do you incorporate climate change into pricing?
Some perils, such as earthquakes, are not climate-related. For hurricanes, climate change appears to affect severity more than frequency, with potentially more intense storms.
Catastrophe models are updated regularly to reflect evolving science and widening types of exposure. Attachment points — the level at which the bond’s principal is threatened — and structures also adjust over time. In my view, climate risk is largely absorbed through structural recalibration rather than through a simple widening of spreads.
So while risk levels evolve, the overall risk–return balance for investors can remain relatively stable.
How do you separate short-term weather volatility from long-term trends?
When we calculate expected loss, we rely on long-term stochastic simulations. These models incorporate structural climate trends but are not designed to trade short-term meteorological forecasts. We are cautious about short-term seasonal predictions — for example, unusually warm sea temperatures — because historically they have not always translated into realised outcomes. What is important is not the number of forecasted events, but where the events make landfall. A single event making landfall in Miami will have a greater impact than several events making landfall in a sparsely populated area. Our approach is anchored in long-term modelling rather than tactical weather views.
What happens to liquidity after major events?
After a major catastrophe, prices of potentially impacted bonds fall and bid–ask spreads widen. It can be more difficult to trade distressed bonds for a period of days or weeks.
However, unaffected bonds usually remain tradable. Because portfolios are diversified, we typically have positions elsewhere that can be transacted if needed. At fund level, we may apply anti-dilution mechanisms so that entering or exiting investors may bear the transaction costs during stressed conditions.
Where do returns come from over a full cycle?
Over the long term, returns are driven primarily by carry — the coupon income. Spread tightening can contribute over shorter periods, but given the relatively short duration, carry dominates.
Floating-rate income has also been a meaningful contributor when interest rates are elevated. But disciplined loss avoidance is just as important as coupon income.
Where are we in the pricing cycle today?
Spreads widened significantly in late 2022 and early 2023. Since then, in the absence of major industry-changing events, spreads have tightened.
We are not at the peak of the cycle anymore, but nor are we at historic lows. If spreads in certain regions tighten excessively — for example in Japanese earthquake — we may reduce allocation, even if it slightly reduces diversification.
How do you maintain discipline when spreads fall?
We assess pricing adequacy relative to expected loss and volatility. If we believe we are not being adequately compensated, we simply do not invest — regardless of market convention.
We are also active in the secondary market when we see better opportunities there. If, after fees, expected returns approach zero, we reduce exposure. Diversification alone is not sufficient justification for taking uncompensated risk.
When spreads are falling, we do not increase risk to maintain the no-loss return at the same level as before. Instead, we adjust the expected no-loss return downwards to maintain the Expected Loss at fund level.
What differentiates your team?
I believe our long track record is a key strength. We have been active since 2007, through multiple catastrophe cycles. We use proprietary portfolio tools and internal modelling capabilities, in addition to external models. We are also selective — we typically invest in around half of marketed transactions rather than buying the market indiscriminately.
Our team can seem demanding for some structuring banks, as we are scrutinising many factors to fully understand the underlying risks, the modelling but also the cat bonds features such as resets and extensions. If the cat bond is not properly structured from our point of view, we will ask for changes.
Ultimately, I think our differentiation lies in disciplined portfolio construction, structural scrutiny and consistent adherence to pricing adequacy — especially when markets become more competitive.
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